Cloud/Saas Public Company Valuation - Q2 2019 Update
Over the last month, I have read about how public Cloud/SaaS company multiples are becoming stretched. The WSJ came out with a piece titled “Investors are too high on the cloud” about how this sector has outperformed for 2 reasons: 1) large corporations are planning to shift more of computing needs to the cloud and 2) cloud companies still have a large addressable market, which ensures growth even in an economic slowdown. VC investor Tom Tunguz wrote on his blog about how public markets are valuing SaaS companies at all-time highs and suggests that much of this is due to multiple expansion. In other words, at the current valuations, buyers believe these companies can execute flawlessly and continue rapid growth for many years. One of the most interesting points made in his analysis was that the most attractive companies (ie. those with the highest valuation) have become more expensive relative to peers. As a rational, analytical finance type, I wanted to examine the data on my own to see if I could gain any other insights.
I selected 51 public Cloud/SaaS companies for my peer group, and for valuation, I used the enterprise value divided by four times the most recent quarters sales number (this is my approximation of annually recurring revenue or ARR). The source of all data is via Morningstar using Quantopian’s research platform. The chart below shows the current median multiple at 9.9x, which is between 1 and 2 standard deviations above the mean of 7.7x over the selected 4.5 year historical period. The chart confirms the strengthening market environment since early 2016 when multiples compressed dramatically. Multiples peaked at 12.0x on 9/5/18, and since then, we have experienced increased volatility.
If we only look at the median chart, it doesn’t tell the entire story. The chart below suggests that high fliers in the top quintile are driving the higher valuations.
The spread has widened to 18.2, which is over 3 standard deviations from the mean of 8.4. While the median in the lowest quintile is currently 4.4x (avg 4.0x), the median of the top quintile has grown to 22.6x (avg 12.4x ). In hot sectors like the Cloud, price momentum and best-in-class SaaS subscription metrics drive the multiple expansion. There has also been M&A activity; the most recent was Salesforce acquiring Tableau Software for $15.7B at a 11.2x EV/ Trailing twelve months revenue multiple.
The following chart confirms that multiples have expanded considerably over the past year. The grey bar is the EV/Est. ARR multiple in 2019 while the blue bar represents the multiple in 2018. The bar chart is sorted from highest to lowest multiple, left to right. Scroll over chart to view companies and multiples. The most expensive is Zoom Video (ZM) at a 47x multiple, which may or may not be justified with sales growth above 100% in the most recent quarter. It also has a net dollar expansion rate of 130%, gross margins above 80%, and an estimated CAC payback period of 9 months (ie. best in class growth + efficiency). On the other end, DOMO is another recent IPO at a 4.4x multiple. It has a long CAC payback period over 80 months, SaaS gross margins at 70%, a blended net revenue retention of just over 100% (enterprise + non-enterprise), negative operating cash flow and recent quarterly sales growth of 29%.
The implications of strong public market valuations are that it often raises the seller expectations in the private markets. With all the noise, it is often hard to discern that only the best-in-class companies are experiencing the strong multiple expansion. In other words, the high fliers are skewing the data. Buyers in the public markets shouldn’t start overpaying because any miss in expectations will result in sizable losses (see ZUO, NEWR). In the private markets, overpaying will certainly make it more difficult to hit the target IRR (Internal Rate of Return), and competition is so fierce in many segments that it may be wise to de-risk the investment by creating a substantial earn-out.